Improving the taxation of trust income - release of discussion paper

Introduction

On 4 March 2011, the Australian Government released a discussion paper on Improving the taxation of trust income (Discussion Paper). This followed the announcement by the Assistant Treasurer on 16 December 2010 that the Government would conduct a public consultation process as the first step towards updating the trust income tax provisions in Division 6 of Part III of the Income Tax Assessment Act 1936 (Cth) (1936 Act) and rewriting them into the Income Tax Assessment Act 1997 (Cth) (1997 Act).

The Discussion Paper said that, while the rewrite of Division 6 is meant to eventually address the current issues with the operation of the provisions (as highlighted by the recent High Court decision in Commissioner of Taxation v Bamford [2010] HCA 10 (Bamford)), there is a need for 'certainty' in the interim and that the Government had therefore decided to amend the law with effect from the 2010-11 income year (i.e. the current year).

The Discussion Paper canvassed interim options for amendment of the law in the following 2 key areas:

• to better align the concept of 'income of the trust estate' (interpreted in Bamford to mean the 'distributable income' for trust law purposes) with the tax law concept of 'net income of the trust estate', in order to 'reduce anomalous outcomes and opportunities to manipulate tax liabilities'; and
• the streaming of capital gains and franked distributions (including the attached franking credits) to particular beneficiaries.

However, in an address to the Institute of Chartered Accountants (ICAA) on 6 April 2011, the Assistant Treasurer said that, as a result of 'overwhelming feedback' from consultation on the Discussion Paper, there will be no interim amendments in relation to trust income and this issue will be rolled into the broader review of trusts.

Accordingly, there will be no immediate changes to the concept of trust income and the only changes proposed for immediate effect are those dealing with streaming.

The Bamford decision

The decision in Bamford clarified that:

• the concept of 'income of the trust estate' in section 97 of the 1936 Act refers to the distributable income of the trust as determined according to trust law (that is, general trust law principles, having regard to the provisions of the trust deed and general accounting principles); and
• 'that share' in section 97 means that 'proportion', such the beneficiary is assessed on the same proportionate share of the trust's taxable income as the proportionate share of the distributable income to which the beneficiary is presently entitled.

The Discussion Paper says the Bamford decision:

• highlights the fact that the amounts on which the beneficiary is assessed may not always match the amounts to which they are entitled under trust law and that this can result in 'unfair outcomes, as well as opportunities to manipulate tax liabilities'; and
• has raised concerns about the extent to which income of a particular character (e.g. capital gains or franked distributions) can be 'streamed' to specific beneficiaries - that is, under the proportionate approach endorsed in Bamford, the amount included in the beneficiary's assessable income under s 97 arguably consists of an undissected proportionate share of the entirety of the trust's taxable income, being a 'blended amount'. Such concerns were increased by the comments of Stone J in the recent case of Colonial First State Investments Ltd v FC of T [2011] FCA 16 (Colonial First State) that the proportion of the income of the trust to which a beneficiary is entitled must be applied to the whole of the net income of the trust.

In response to the Bamford decision, the Australian Taxation Office (ATO) withdrew its previous practices and rulings in relation to these issues, including:

• TR 92/13 - dealing with trust dividends and franking, in which the ATO accepted that income distributed by a trustee of a trust estate retains the character it had when it was derived by the trustee and different types of trust income, such as franked dividends and interest, could be streamed to different beneficiaries, subject to the trust deed; and
• PS LA 2005/1 (GA) - dealing with the taxation of trust capital gains, in which the ATO said it would accept either the 'proportionate approach' or the 'capital beneficiary approach' (in which the capital gain would be assessed to the capital beneficiaries who were entitled to it).

The ATO issued PS LA 2010/1 on 2 June 2010 setting out the approach it would take in respect of compliance activities, rulings and disputes involving Division 6. In short, while the ATO will not undertake active compliance in relation to the 2009-10 and earlier income years simply to correct errors based on a view of the law that may be inconsistent with Bamford, it will nevertheless now administer and apply the law on the basis as explained in that case.

This has left considerable uncertainty and potential for anomalous outcomes in relation to the taxation of trusts, for example in relation to franked dividends derived by a trust where the franked dividends were distributed to some beneficiaries and other types of income to other beneficiaries or in relation to capital gains derived by a trust with different income and capital beneficiaries.

Streaming of franked dividends and capital gains

The Discussion Paper proposes that Subdivision 207-B of the 1997 Act (dealing with distribution s of franked dividends and entitlements to attached franking credits) and Subdivision 115-C (dealing with net capital gains of a trust) be amended to enable franked distributions and capital gains to be streamed for tax purposes.

Subdivision 207-B will be amended to clarify how the operation of Division 6 is modified where a trustee receives a franked dividend, to ensure that the franking credits are not brought to account in all beneficiaries' assessable income where the franked dividends are distributed only to one beneficiary or some beneficiaries and not others. This will ensure that the franking credits are only included in the assessable income of the beneficiaries who are entitled to the tax offset.

For trust capital gains, the interaction between Subdivision 115-C and Division 6 will be clarified. Subdivision 115-C will be amended to ensure that the amount of a trust's capital gain deemed to have been made by a beneficiary reflects the beneficiary's entitlement to that gain for trust law purposes and that a beneficiary who is not entitled to a share in a capital gain of the trust under the deed will not be taken to have an extra capital gain under Subdivision 115-C.

As noted above, these changes are proposed to apply in and from the current year of income.

The proposed amendments will apply to all trusts (other than trusts that are taxed as companies), including discretionary family trusts, other private trusts (discretionary, fixed, unitised or hybrid) and managed investment trusts (MITs) (registered and unregistered managed investment schemes, retail and wholesale).

The Discussion Paper does not deal with character flow-through and streaming of other types of trust income, such as interest, royalties, rental income and foreign source income.

Options for aligning the concepts of distributable income and taxable income

As noted above, the Government is now not proposing to introduce interim changes to the concept of 'income of the trust' but will consider this issue as part of the wider review of the trust taxation provisions.

Briefly, the 3 options canvassed in Discussion Paper for better aligning the trust law concept of 'distributable income' with the tax law concept of 'taxable (or net) income' were to define 'distributable income':

(a) to be equal to the taxable income of the trust, subject to adjustments to reflect the actual amount available for distribution to beneficiaries (e.g. by excluding some or all 'notional' amounts of income or expenses, such as franking credits, deemed dividends and deductions for new business investments); or
(b) with reference to generally accepted accounting principles; or
(c) with reference to the trust deed and trust law principles but with capital gains being specifically included, possibly subject to a specific antiavoidance provision to ensure that tax liabilities could not be manipulated. This was regarded as a 'minimalist' approach.

The Discussion Paper did not address the concept of 'present entitlement' in s 97 of the 1936 Act.

Managed Investment Trusts

The Assistant Treasurer also announced in his address to the ICAA that (again in response to 'overwhelming feedback') the start date for the proposed new 'attribution' tax regime for MITs has been moved to 1 July 2012. In the meantime, the general trust provisions in Division 6, including the proposed interim amendments, will continue to apply to MITs.

Conclusion

The proposed interim measures (applicable from the current year) will deal only with specific issues in relation to streaming of franked distributions and capital gains, pending the wider review and rewrite of the trust taxation provisions.

It is hoped that this wider review will eventually address all of the issues that arise under the current trust provisions, including in relation to the concept of 'distributable income' and other issues (such as present entitlement, the flowthrough and streaming of other types of income and the definition of 'fixed trust'¹) and that it will deliver more fundamental reform. There is currently no proposed timetable for these reforms.

Some trust deeds may need to be amended in light of the proposed amendments (giving rise to potential resettlement issues). Trustees will need to monitor the progress of the measures.

 

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¹ The definition of 'fixed trust' is relevant for trust losses and the ability of beneficiaries to access franking credit benefits and arguably should also be urgently addressed, particularly as the decision in Colonial First State has cast further doubt on the ability of registered managed investment funds to satisfy the definition.

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